Rating agencies

Let go of nanny

The case for taking credit ratings out of financial regulation

IT SOUNDS like a great new idea. Avoid heavy-handed central regulation. Instead, harness market forces, in the shape of private-sector credit-rating agencies. Protect investors and banks by using their ratings in your rules for capital adequacy and investment. Best of all, because companies themselves pay for the ratings, it can all be done at zero cost.

In fact, it is not a new idea at all. Ratings have been used by regulators since America's Investment Company Act of 1940, which laid down that money-market funds could invest only in high-quality assets, determined by what came to be known as investment-grade ratings. Over the past few decades, regulators have become ever more reliant on credit ratings; the Securities and Exchange Commission (SEC) has even established “nationally recognised statistical rating organisations”. Only three agencies qualify: Standard & Poor's, Moody's and Fitch. They have become big businesses, moving into ever more exotic financial instruments, offering to pre-rate securities planned by an issuer, and selling advisory services. Bank supervisors now plan to incorporate ratings into the revised Basel accords on bank capital standards.

What could be wrong with all this? Plenty, as it happens. A new report by the SEC, commissioned by last year's Sarbanes-Oxley act, has ventilated some of the possible drawbacks (see article). But it dithers over possible cures, and steers away altogether from by far the most sensible idea: to reverse the trend of the past 60 years, and start taking credit ratings out of financial regulation altogether.

It is not that the rating agencies do such a terrible job. Yes, their ratings of sovereign debt failed to warn of the East Asian crisis of 1997—but then, so did the International Monetary Fund. The agencies have also taken flak for not noticing that Enron and WorldCom were going bust—but then, neither did these firms' auditors. By comparison with credulous Wall Street analysts, who kept near-perpetual buy recommendations on shares right through the bursting of the stockmarket bubble, credit raters seem models of sober judgment.

And yet the rating agencies share some of the problems of the analysts. The most obvious is conflicts of interest. Not only are they beholden for their fees to companies whose securities they rate; they often sell the same clients a parcel of advisory services. Just as for audit firms, which did likewise until Sarbanes-Oxley stopped them, the temptation is to keep up ratings in return. Then there is the issue of competition. The SEC has bestowed recognised status on several newcomers in the past 30 years—but those have since merged into the original three. The agencies move in near-lockstep, in fees and in the ratings they give.

It gets worse. As ratings have been more widely used in regulation, they have begun to affect the market, in a version of Goodhart's law (that any variable chosen as a monetary-policy target immediately starts to behave differently). Because regulators and banks use ratings to assess credit risk, a rating downgrade can itself become a trigger requiring higher interest payments from a borrower or even driving it into bankruptcy. Similarly, rather as teachers often teach to the test, financial instruments are increasingly designed solely to carry a particular rating, not the other way round. The effect of both distortions is to discourage agencies from changing ratings on objective grounds until it is too late.

Imprisonment or freedom

There are, in principle, two different cures for these ills. One, which the SEC appears to favour, is to increase the supervision and regulation of the rating agencies. Stop them offering advisory services to clients, for instance; set new rules for the behaviour and pay of their staff; or impose competition by recognising more agencies.

The trouble is that such measures would increase, not reduce, the burden and cost of regulation. Hence the appeal of the second cure: take ratings out of regulation altogether, and return the agencies to their role as servants not masters of the capital markets. Capital-adequacy rules could be set using other risk measures, such as the spreads at which securities actually trade in the markets. Restrictions on investments should mostly be scrapped: it makes no sense to insist that funds buy only investment-grade bonds when they can buy any old equities, which are often riskier than even junk bonds.

The analogy with equities is worth pondering. Suppose regulators ruled that retail investors or mutual funds could buy shares only if a majority of investment-bank analysts had a buy recommendation on them. Would that protect investors, or improve the analysts? Hardly: yet it is, in essence, what happens for many debt securities. It is time for regulators and investors to let go of their rating-agency nannies.